This morning, the Supreme Court heard arguments in Jones v. Harris Associates. It's a case that could either fundamentally alter the mutual fund industry or strongly reinforce the status quo. It has attracted quite a bit of attention, including pieces in the op-ed pages of both the New York Times and the Wall Street Journal. Why is it so important and why should you care? Let's take a look.
The case concerns mutual fund expenses: whether or not mutual fund boards of directors are doing a sufficient job in representing the interests of investors in negotiating fees with fund managers, and what recourse investors have if they feel their interests are not being served. If the lower court's ruling is upheld, the Supreme Court will essentially be endorsing the current system, and fund shareholders will have little -- and perhaps zero -- chance of seeking redress through the court system. If the lower court's ruling is overturned, however, it could result in much greater scrutiny of the process by which mutual managers and directors negotiate fees; scrutiny that would almost certainly result in lower fund expenses.
Congress, Mutual Fund Fees and Economies of Scale
Investment management is a field dominated by economies of scale. There are a certain amount of fixed costs in managing money -- salaries, administrative expenses, and the like. But those expenses remain largely flat as the assets under management increase. It doesn't cost a manager much more to run a $10 billion fund than it does to run one with $100 million in assets. Thus a fund that was mildly profitable charging an expense ratio of 0.7 percent with $500 million of assets will become staggeringly profitable if that same expense ratio is in place as assets rise to $5 billion.
Further complicating matters is the fact that money managers face a direct conflict of interest in setting the fees they charge. Higher fees benefit them, obviously, but detract dollar for dollar from the returns earned by their fund's investors.
Recognizing these facts, Congress passed a law in 1970 which added Section 36(b) to the Investment Company Act of 1940. In an effort to ensure that mutual fund managers share their economies of scale with fund investors, 36(b) established that investment advisors "have a fiduciary duty with respect to ... compensation," and gave mutual fund investors the right to sue their investment advisors for violating that duty.
What is a fiduciary duty? Black's Law Dictionary defines it as "a duty to act with the highest degree of honesty and loyalty ... and in the best interests of the other person" to whom that duty is owed (emphasis added). Functionally, then, 36(b) established that mutual fund managers and directors must act solely in the interests of fund investors in setting mutual fund fees, and not in the interests of fund managers.
The Courts Weigh In
Of course, it was up to the courts to interpret this legislation, and the precedent was set in 1982, in a case known as Gartenberg v. Merrill Lynch Asset Management. The court ruled in favor of Merrill Lynch, finding that in order to breach 36(b), a fee must be "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." Further, in determining what is disproportionately large, the court ruled that one of the factors that should be considered was the fees charged by similar funds.
The die was cast, and Gartenberg set a very high bar for mutual fund shareholders, in no small part because the fees they were charged could be compared to the fees charged by other funds, which were also set by mutual fund boards dominated by fund managers. The hurdle was so high, in fact, that some 27 years later, mutual fund shareholders have yet to win an excessive fee case.
But the cases still came, including Jones v. Harris Associates. I wrote about this case earlier (here, here and here), but briefly, Harris Associates was sued by owners of its Oakmark funds because the advisory fees they pay are more than twice as large as the advisory fees that Harris Associates' institutional clients are charged. The shareholders claim that this discrepancy is a violation of 36(b), and clearly demonstrates that the funds' board of directors is not negotiating the lowest fees possible on their behalf.
Unsurprisingly, lower courts ruled in favor of the defendants. And the case, like the many before it, might have passed well below the Supreme Court's radar had it not been for the strong -- and differing -- opinions it elicited from two highly-regarded conservative jurists on the Seventh Circuit Court of Appeals, Judge Frank Easterbrook and Judge Richard Posner.
Writing for the majority, Judge Easterbrook actually overturned the Gartenberg standard, stating that mutual fund fees should not be subject to judicial review (as established in 36(b)), but should be established by the free market. "A fiduciary," wrote Easterbrook, "must make full disclosure and play no tricks but is not subject to a cap in compensation."
Absent outright fraud, according to Easterbrook, the courts should play no role in determining the appropriateness of mutual fund fees. He went on to compare the mutual fund industry to the automotive industry, writing that it made as little sense for the courts to weigh in on mutual fund expenses as it would for courts to set prices for cars.
Not so fast, said Posner in his dissenting opinion. Easterbrook's logic is based on "an economic analysis that is ripe for reexamination," wrote Posner, who argued that there is a great deal of evidence that shows that boards of directors have "feeble incentives" in policing compensation, and that "competition ... can't be counted on to solve the problem."
With the global financial crisis as an intriguing backdrop to this highly-charged debate between two such respected legal minds, it's little wonder that the case caught the attention of the Supreme Court.
Why Easterbrook is Wrong
I'm not a legal scholar, but I am solidly in Posner's camp. As I see it, there are several flaws in Easterbrook's logic, perhaps none greater than his reliance on free markets in setting mutual fund fees.
The power of competition and free markets requires no real defense, and there's ample evidence that in most cases market participants, seeking nothing more than to maximize their own self-interest, serve as a remarkable regulator. But in light of the financial meltdown we've just endured, there is also a good deal of evidence that a marketplace's actors do not always act rationally.
Was it rational, for instance, for investment bankers to be compensated based on the number of mortgage-backed securities they brought to market without any concern for the credit-worthiness of the mortgages those securities owned? Was it rational for home buyers to pay two or three times the amount they could afford for a home simply because their lender didn't seem to care? Was it rational for AIG to write billions of dollars worth of credit default swaps that they could never dream of paying off if the bonds they were insuring actually defaulted? Of course not.
This disconnect between economic theory and reality is the basis of the field of behavioral economics. Traditional economic theory assumes that markets are made up of rational participants, who calmly and coolly assess risks and benefits, and always act appropriately. Behavioral economics says that market participants (humans, in other words) are not always rational, and are prone to making decisions that are in direct conflict with their own self-interest.
And decades of experience strongly indicates that there is no better illustration of the irrationality of market participants than the mutual fund industry.
For instance, counter to Easterbrook's logic, there is very little evidence that mutual fund investors consider expenses in making their investment decisions. Indeed, a 2005 study of fund flows and expenses found the opposite to be true: "[T]here is at best no relation, and at worst, a perverse positive relation, between fund flows and operating expenses." Yes, the authors fund that in the 29-year period they examined, the highest-cost funds grew at a faster rate than the lowest-cost funds. In fact, the assets of the lowest-cost funds actually shrank.
Need more evidence? A 1998 survey of 2,000 fund investors found that only 19 percent could estimate the expense ratio of their largest mutual fund holding. But that's not the worst of it. An amazing 84 percent of those surveyed believed that funds with above-average expenses produced average or above-average performance.
If most investors mistakenly believe that higher costs produce higher returns, and mutual fund managers benefit from higher costs, how surprised can we be that fund expenses have risen dramatically over time?
Even if investors were rational, Easterbrook's logic ignores the millions of Americans own mutual funds solely through their employer-sponsored retirement plans. Owners of these accounts do not have the option of voting with their feet, as Easterbrook would have them do, because the funds in the plan are chosen by their employer. Thus, an employee in a plan laden with high-cost options would have to choose between forgoing retirement savings or paying the sort of outsized fees that 36(b) was designed to prevent.
But what was perhaps most troubling about Easterbrook's decision was his comparison of the mutual fund industry to the automotive industry. Despite Easterbrook's equivalence of the two, there is in fact a great deal of difference between them. Indeed, the recognition of the unique characteristics of the mutual fund industry is what led Congress -- nearly 40 years ago -- to establish that fund managers owe their clients a fiduciary duty.
Congress even went a step further, and established that fund managers have a fiduciary duty with respect to compensation. That is, in setting their fees, Congress said that mutual fund managers are not simply allowed to charge what the market will bear. Instead, because of the unique conflicts of interest inherent in the industry, Congress explicitly determined that the reasonableness of a fund manager's fee should be considered in light of the manager's duty to act solely in their clients' best interest in setting those fees. Unless and until Congress passes legislation that holds automobile manufacturers to such a fiduciary duty in setting their prices, the comparison is moot.
Reaffirming the Primacy of Investors
In the 39 years since Congress determined that mutual fund fees warrant greater scrutiny, the mutual fund industry has grown from a relative bit player in the financial markets, with but $48 billion in assets, to a colossus, with assets of $10 trillion.
Given the vastly important role mutual funds play in the long-term financial well-being of some 92 million Americans, and with the inadequacy of our current retirement system and the financial crisis serving as important backdrops, now seems to be a particularly opportune time for our nation's highest court to make a careful examination of just how well the mutual fund industry is measuring up to the standards that Congress long ago applied to it.
Just who will prevail when the Supreme Court's decision is handed down in June is anyone's guess. But if a dyed-in-the-wool believer in the power of markets like Judge Richard Posner can see through the fog and recognize the industry's shortcomings, there is reason to hope that five Supreme Court justices will be able to as well, and take an important step in establishing -- once and for all -- that mutual funds must be run with the interests of fund investors held paramount.